Heartland Financial USA, Inc.
Q2 2015 Earnings Call Transcript

Published: 28 Jul 2015

[Operator:]

Greetings, and welcome to the Heartland Financial USA Incorporated Second Quarter 2015 Conference Call. This afternoon, Heartland distributed its second quarter press release, and hopefully you have had a chance to review these results. If there is anyone on this call who did not receive a copy, you may access it at Heartland's website at www.htlf.com. With us today from Management are Lynn Fuller, Chairman and Chief Executive Officer; Bryan McKeag, Chief Financial Officer; and Ken Erickson, Executive Vice President and Chief Credit Officer. Management will provide a brief summary of the quarter and then we will open up the call to your questions. Before we begin the presentation, I would like to remind everyone that some of the information management will be providing today falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission. As part of these guidelines, I must point out that any statements during this presentation concerning the Company's hopes, beliefs, expectations and predictions of the future are forward-looking statements and actual results could differ materially from those projected. Additional information on these factors is included from time-to-time in the Company's 10-K and 10-Q filings, which may be obtained on the Company's website or the SEC's website. At this time, all participants are in a listen-only mode [Operator Instructions]. As a reminder, this conference is being recorded. At this time, I will now turn the call over to Mr. Lynn Fuller at Heartland. Please go ahead, sir.

[Lynn Fuller:]

Thank you, Sherry, and good afternoon. We certainly appreciate everyone joining us today as we discuss Heartland's performance for the second quarter of 2015. For the next few minutes, I will touch on the highlights for the quarter I'll then turn the call over to Bryan McKeag, our Executive Vice President and Chief Financial Officer, who will provide additional color on Heartland's quarterly results. Then Ken Erickson, our EVP and Chief Credit Officer, will offer insights on credit-related topics. While I am very pleased to open my remarks this afternoon with news that Heartland reported another excellent quarter with net income available to common shareholders of $15 million, that is $10.6 million over Q1 2014. On a per share basis, Heartland earned $0.72 per diluted common share for the quarter compared to the $0.56 per diluted common share for the same quarter last year. Year-to-date net income available to common stockholders of $30.5 million or $1.47 per diluted common share compares quite favorably with earnings of $17.3 million or $0.92 per common share for the first half of 2014. Our trailing 12 months earnings per diluted common share were $2.75. While annualized return on average common equity for the quarter was 12.26% and return on average tangible common equity was 14.14%, our tangible capital ratio remained steady at 6.46% for the quarter and near the midpoint of our target range of 6% to 7%. Book value and tangible book value per common share continued to increase and ended the quarter $24.13 and $20.84, respectively. While a number of our second quarter financial performance metrics improved from the exceptional performance metrics for the first quarter of 2015, net interest margin for example, improved to 3.7% from 3.90% in Q1. Our success in maintaining margin above many of our peers is a result of continuous pricing discipline on both sides of the balance sheet, net interest income in dollars also improved nicely over previous quarters. While looking at the balance sheet, total assets increased during the quarter to $6.7 billion, largely attributed to our solid loan growth. Following the slow first quarter, Heartland recorded very strong organic loan growth of $206 million during the quarter. Growth in quality loans remains our number one priority and pipelines point towards continued growth. Credit quality remains exceptional, with non-performing loans to total loans at 60 basis points, a four-basis point improvement over the previous quarter. In a few minutes, Ken Erickson standards will provide more detail on credit related topics. With our securities portfolio now representing 24% in total assets, our strategy of converting cash flow from our securities portfolio into quality loans is nearing a successful conclusion. Going forward, our strategy will shift to generating organic deposits to fund expected loan growth, with emphasis on non-maturity demand savings and money market deposits. The tax equivalent yield on our securities portfolio decreased 21 basis points to 2.71%, while our duration declined slightly to 3.7 years. The drop in yield was offset by a 3.1 million gain on sale securities. While Heartland's residential real estate division experienced an excellent quarter with originations of $422 million an increase of 32% over the first quarter of this year and 53% over the same quarter last year. We continue to experience good momentum with June's purchased the re-fi ratio reaching 70

[Ken Erickson:]

Thank you, Bryan, good afternoon. I will begin by discussing the change in non-performing loans and other real estate owned. This quarter resulted in non-performing loans being reduced from 0.64% to 0.6% of total loan. There are only three non-performing loans with individual loan balances exceeding $1 million. In aggregate, these loans totaled $5.8 million or 21.6% of our total non-performing loan. $10.3 million or 38.6% of our non-performing loan are in our retail portfolio of consumer and residential real estate loan. This level of non-performing retail loans have been relatively constant. 30-day to 89-day delinquencies decreased to 31-basis point. Other real estate owned decreased by $2.1 million in the second quarter to $17 million. Non-performing assets as a percent of total assets was reduced from 72-basis point to 66-basis point. Other real estate owned continue to sell at or near book value, 3.4 million in cumulative sale of 21 of other real estate properties was recorded in the second quarter, which represented 17.7% of all the other real estate owned as of March 31st. Net loss on repossessed assets, which includes the gain or loss upon sale of the asset, was $563,000. Collection, ORE and repo expense was $753,000 for the quarter. Our existing portfolio other real estate is made up of 16 residential properties aggregating to $3 million and 47 commercial properties that aggregate to $13.9 million. Provision expense was $5.7 million in the second quarter, a $4 million increase from the first quarter. The majority of the increase is the result of much higher loan growth and the effect of purchase accounting. Higher organic loan growth this quarter accounted for $2.6 million of the increase and another $600,000 is related to valuation changes on purchased impaired loan related to our Sheboygan acquisition. The remaining increase is primarily attributable to the close-out of the purchase accounting, valuation reserve and corresponding provision necessary to establish an allowance for these remaining loans from the Freedom and Morrill & Janes Bank acquisition. As stated last quarter, the provision expense was expected to increase in future quarters. As our loan growth began to materialize. In addition, $510.6 million of loan from our Sheboygan acquisition still reside in the purchase accounting pool and are covered by the valuation reserve. As credit decisions are made on these accounts in future quarters, the provision expense will be necessary to establish the associated allowance for those loans. Net charge-offs were $1.9 million for the second quarter, $655,000 of this amount was taken by our consumer finance company, resulting in only $1.3 million of net charge-off for the bank portfolio. As shown in the earnings release, our coverage ratio of allowance for loan and leased losses as a percent of non-performing loans and leases was 171%, up from 154.83% as shown at the end of March. The coverage ratio should continue to increase as non-performing loans are reduced in future quarters and as loans currently covered by the valuation reserve migrate out of purchase accounting pool and have an allowance established for them. The allowance for loan and lease losses as a percent of loans and leases increased from 0.99% to 1.03% this quarter. The valuation reserve of $14.8 million is recorded for those loans obtained in acquisition, excluding those loans would result of the ratio of 1.1%, which would compare to 1.14% at March 31st. As mentioned by both, Lynn and Bryan, our loan growth was extremely strong this past quarter. Within the commercial and agricultural portfolio, new loan production resulted in $164.8 million of increased outstanding, 47% of the new loan production in the second quarter was in C&I and 31% was in commercial real estate of which half of the CRE loans were owner-occupied. While we have been successful in moving some business from our competitors, 70% of the new money disbursed in the second quarter was for new projects or expansion. All of our banks sharing this growth with the largest growth coming from Wisconsin Bank & Trust, who had 19% of the total new production. We have not seen a significant push towards fixed rate approximately half of the new production with fixed rate loan. These new loans were also relatively granular additions to our portfolio, with only nine exceeding $5 million, the largest being $13.8 million. Residential real estate and consumer loans also had solid growth with $29.1 million, $12.5 million of second-quarter growth, respectively. Our banks remain very positive that their annual loan growth goals are attainable. Our agricultural borrowers did well in 2014, dairy had excellent milk prices, and hog prices were good, which led to reasonable profitability, cattle producers had an excellent year; cash grain was the weakest with commodity prices lower. For 2015, hog prices are down, but it is expected that the dairy industry will be able to handle the reduced price level and remain reasonably profitable. Hog prices are lower, but feed cost have also been reduced. Our ag lenders do not foresee any issues in the swine industry. Replacement feed or cattle prices have risen, but existing prices should be sufficient to be profitable in 2015. Current corn and soybean prices are slightly better than the breakeven prices for most cash grain operators. Most of the intended acres were planted without weather interruptions this spring. Those that were not are protected by crop insurance coverage. In summary, livestock should be fine, grain operators may suffer some, but with the protection of crop insurance and the government program, we do not expect to see any significant changes in the portfolio quality. On a personal note, I would like to announce that I have given notice of my intent to retire in the first quarter of 2016. I know Lynn has a few comments that he would like to make in regards to my future retirement, so with that I will turn the call back to you, Lynn, and remain available for questions.

[Lynn Fuller:]

Thank you, Ken. Ken has certainly had a long and wonderful career with Heartland, and we are deeply indebted to him for his nearly 40 years of service to the company. We truly appreciate everything Ken has done for us over the years and the fact that we have never suffered a loss year is a testament to the strong credit culture he has maintained as Heartland's Chief Credit Officer. With Ken's leadership, Heartland has the strongest credit team and its history and with a carefully develop succession plan, he has spent the last two years mentoring his successor Drew Townsend, who will assume the role of Chief Credit Officer in Q1 2016. Well, Ken on behalf of Heartland, our member banks and Citizens Finance, we truly appreciate the tremendous contribution you have made to Heartland and wish you the very best in your impending retirement. Now, we can open the phones for your questions.

[Operator:]

Thank you. We will now be conducting a question and answer session. [Operator Instructions] Our first question comes from Jeff Rulis from D.A. Davidson.

[Jeff Rulis:]

Thanks. Good afternoon.

[Lynn Fuller:]

Hi, Jeff.

[Jeff Rulis:]

Bryan, on the expense discussion, the $63.5 million I am trying to just get into, I guess, if we could exclude one-timers, what you excluding is the $2.2 million in the tax credit investment and then the other was another figure in that number?

[Bryan McKeag:]

There is another $1 million of write-offs that is sitting in the other expense line. It is in the losses on sale of assets, I think, line. Sorry.

[Bryan McKeag:]

There are no, I guess, cost savings expected going forward? I mean, you had the conversion of the capacity. Then I guess the upcoming deal is separate from all that, but we are looking at about right around $60 million on a quarterly basis.

[Bryan McKeag:]

Yes. I think so, I think it is between $59 million and $60 million is kind of where I would peg it. There would probably a little bit of cost savings, but it should be somewhere in that range.

[Jeff Rulis:]

Got you. With that, you do not expected to take any tax credit investments and then the tax rates goes back to the - what rate would you have?

[Ken Erickson:]

We have other tax investment that we are working on, but the timing of which is always when they pass inspection, when we are able to take them. I am never sure exactly when those are going to hit. Sometimes even until the last month of whatever quarter they might hit, so I think there will be one or two more before the end of the year possibly, but they could both come in the fourth quarter or there could be one in the third and the fourth quarter. I am not exactly sure.

[Jeff Rulis:]

Sound good. Okay. Then, Butch, a couple of questions on just the M&A landscape, one, you mentioned pretty specific deal closings on the first two. I did not know if you had any thoughts on Premier Valley, when that closes in Q4, early or late?

[Lynn Fuller:]

I think, we should be somewhere mid-Q4. I would expect about the mid-Q4. Then we do not convert them though until the first quarter next year, it is just when conversions take place first quarter next year.

[Jeff Rulis:]

And that is four or three or just Premier Valley?

[Lynn Fuller:]

No. The other two small ones that are getting merged into our existing charters, New Mexico and Arizona, those will get converted this year.

[Jeff Rulis:]

Okay. Then Butch, you mentioned those discussions with additional deals in your appetite, I guess, any other colors as far as where in the footprint that would be or they have similar size and/or from transactions you have had historically. Anything to add?

[Lynn Fuller:]

They would be more similar to Premier Valley in size. They would be in footprint. If we can announce one or two more this year, they would simply be announced. They would not close until next year. Then conversions would have to follow Premier Valley in the first quarter.

[Jeff Rulis:]

Great. Thank you.

[Lynn Fuller:]

Okay.

[Operator:]

Thank you. Our next question comes from Jon Arfstrom from RBC Capital Markets.

[Jon Arfstrom:]

Yes. Thanks. Good afternoon.

[Lynn Fuller:]

Hi, Jon.

[Bryan McKeag:]

Hi, Jon.

[Jon Arfstrom:]

Just a follow-up on M&A, Butch, it sounds like there is some decent activity pretty common theme that you are hearing from the sellers. I mean, what it seems like the activities pickup a bit, is there anything you can shed light on there?

[Lynn Fuller:]

Well, as I said in the past, some of these deals have been in the works for some time and some of them will go as quickly as six to nine months and others will be years. The ones that I am thinking about, we have been talking to a number of these folks for some time. They tend to be more of a size of Premier Valley, they are not the small deals, but they are in footprint. What I hear from the sellers are that $100 billion, they really struggle with the cost of technology, the cost of talent, the cost of compliance. With sustained low interest rates in income coming out of recession, it has been a struggle for our banks to maintain their NIM, their cost structure keeps going up and their gross profit margins going down. Then you layer on top of that that succession planning is in place and the ownership is looking for liquidity. They just do not have liquidity in a non-publicly traded bank, so it is a combination of pressures that are hitting the smaller than $1 billion-type of shops. We do not hear as much of that from the larger banks, $1 billion and up, but it is gets pretty consistent with the smaller banks.

[Jon Arfstrom:]

Okay. Good. That is helpful. Maybe Bryan for you, just on the efficiency projects, what are you targeting, where are the opportunities to bring the efficiency ratio down?

[Bryan McKeag:]

I think, as we said this quarter, we closed some of our lower performing mortgage offices. I think, we will be continuing to look at our footprint, both in the bank side and the mortgage side to try some opportunities there. I think, we are looking at some of the operations area for example. In our area, we are looking to automate some of reconciliation processes that we are little more - annual right now, so it is those types of things that we can do. Some of those will result in more immediate efficiency gains, some will help us as we grow not to have to add.

[Jon Arfstrom:]

Okay.

[Bryan McKeag:]

Jon, a good portion of cost saves and increasing productivity came out of our branches as we implemented our retail vision and we are seeing better sales, we are seeing more services per household, we are seeing better penetration per consumer credit and yet we are doing with fewer FTEs that are cross-trained and capable of doing more with less FTEs, so a number of the benefits we are receiving would be technology related such as the automated account reconciliation is good example one of those, ACL in the credit area Ken is more familiar with that, but that is going to automate some of the credit process. I guess, the number of things that we are doing to get up to speed on technology, which brings us processes that are scalable, so that when we add banks, we are not having to add as many FTEs per $1 million of earning assets and I think you will continue to see that over the next year-and-a-half to two years.

[Jon Arfstrom:]

Okay. Then just on the deposit, call it, the earning assets mix and deposit strategy you talk about the securities portfolio being where you want it. You probably just got a couple of deposit rich acquisition closing, but what changes in your approach on deposits in terms of funding your stronger loan pipeline with deposits?

[Ken Erickson:]

I mean, we have for years had as one of our top priorities continued core organic growth of non-time DDA and low cost savings products and that continues. A big part of that strategy is our treasury management products, which are pretty darn robust now and that gives us an opportunity to bring in larger deposits from a cash-rich commercial accounts and that is a primary focus for our commercial relationship managers, as well as for our treasury people. On the retail side that is just primary the focus. I mean, we are looking to continue with small businesses, generate good solid non-time deposits. I mean, in the last five years, Bryan, it has been one of the top priorities and it was behind the loan growth for a couple of years, because our deposits actually grew our loan demand.

[Jon Arfstrom:]

Right.

[Ken Erickson:]

Yes. The core deposit piece have always been something that we have been after and wind grow, we probably have been not as aggressive on pricing CDs, because of the environment and our mix of deposits and loans a couple of two, three years back, but I think we are at that point where we need deposits.

[Bryan McKeag:]

Exactly. That is something we look at with every M&A transaction too. We really look to see if the bank has extremely attractive deposit mix and low-cost funding. The recent acquisitions are all in the low teens for a cost of funds.

[Jon Arfstrom:]

Okay. Then just one last thing I want to say congratulations to Ken. Job well done over the last several years, so congrats.

[Ken Erickson:]

Thanks, Jon.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from Damon DelMonte from KBW.

[Damon DelMonte:]

Hey, guys good morning guys. How are you doing?

[Lynn Fuller:]

Good.

[Bryan McKeag:]

Hi Damon.

[Damon DelMonte:]

Great. My first question is just regarding the outlook for loan growth. Could you just talk a little bit about the pipeline at the end of the second quarter and kind of how it looks going in to the third quarter just given the strength that you saw this the past quarter?

[Lynn Fuller:]

Yes. I have polled our bank, Damon, and they feel fairly confident that the 2% growth that Bryan mentioned that we have per quarter will continue. The second quarter growth depend over the top, but some of that was a little carry or from the first quarter. They have got some pretty robust pipelines and feel fairly confident that will continue, not at the pace what we saw in the second quarter, but we will be strong in the third.

[Damon DelMonte:]

Okay. Great. Then with regards to the margin, Bryan, I think you said the range for the margin will be like 385 to 395, so this quarter was I think 397. Where there some non-core items in there this quarter or are you guys expecting that amount of compression over the next few quarters?

[Bryan McKeag:]

Yes. I think, I was a little surprised maybe at tick or two this quarter of where it came in. We have got purchase accounting that goes through and we got a couple of banks that were coming to the end of some of their purchase accounting, we have got some new banks coming on, so there is going to be a little bit of noise and fluctuation here over the next couple of quarters. I will tell you, fees can drop a little bit and we lose some basis point, so I think it is hard to see it going higher given the environment. Therefore, I think probably that next 10 basis points below where we are somewhere between here and there is the right spot.

[Ken Erickson:]

Okay. Jon had asked the question, Damon, about where we were with respect to the portfolios as far as a percent of assets. We typically would be somewhere between that 20% to 24%, so there was probably a little bit more room to continue to let some investments run off and put into loans and that will help our margin, but the investment portfolio did drop in yield. If we stay at these lower rates, it is going to be more and more challenging to maintain that margin.

[Damon DelMonte:]

Okay. Great. Then my last question relating to the provision, in the press release I know you noted that it was higher in part due to the loan growth, and I may have missed something in your prepared remarks, but is that is what really drove the provision to be roughly $5.7 million this quarter and how should we think about the provision in the upcoming quarters?

[Lynn Fuller:]

I think for a loan growth factor in about 115 or 120 for loan growth, and you can see net charge-offs have been in that 15-basis point range. I think, if you combine those two, will come close. We had a decrease in loans in the first quarter as you recall, so we had over $200 million this quarter, so a lot of provision expense just for the new loan growth. Then for the purchase accounting, there are some things going with a couple of banks they came to the tail end up there. Although higher coming from the valuation reserve into provision in this quarter, but just for loan growth and charge-offs, I think you can factor in the 15-basis point the loss plus or minus and then 115 to 120 on new loans.

[Damon DelMonte:]

Okay. That is helpful. Congratulations, Ken, on a great career.

[Ken Erickson:]

Okay. Thank you.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from Andrew Liesch from Sandler O'Neill.

[Andrew Liesch:]

Hey, everyone.

[Lynn Fuller:]

Hi, Andrew.

[Bryan McKeag:]

Hi, Andrew.

[Andrew Liesch:]

Just one question, Bryan, can you pleased walk me through the gain sale of loan line of $14.6 million? Were there any hedging gains in there or write-up of the mortgage servicing rights?

[Bryan McKeag:]

There was no write up of the mortgage servicing rights. We do, as almost all banks do, mark our pipeline and locked pipeline in our warehouse to the lowered cost to market and the pipeline to market, so that is in there. We do that every month and every quarter, so that is consistent from quarter-to-quarter. The pipeline stayed relatively the same size as it was, so that is good because that means we continue to fill up the warehouse and our throughput, so there really was nothing super unusual other than we just had good volumes that continued from the first quarter into the second quarter.

[Andrew Liesch:]

Got it. On the loan growth, were there any loan purchases in the quarter or was it all organic originated growth?

[Bryan McKeag:]

No. It is all organic.

[Andrew Liesch:]

Wonderful. Ken congratulations on your retirement that is all.

[Ken Erickson:]

Thanks, Andrew.

[Andrew Liesch:]

Thanks guys.

[Ken Erickson:]

Thanks.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from Daniel Cardenas from Raymond James.

[Daniel Cardenas:]

Good afternoon, guys.

[Bryan McKeag:]

Hi, Daniel.

[Daniel Cardenas:]

Just quick question, if you guys can remind me when does your SBLF preferred stock, I wonder, when is the rate reset on that?

[Bryan McKeag:]

March of '16 and we will be paying it off March of '16.

[Daniel Cardenas:]

Yes. Are you going to be raising funds to that or you are going to do that with cash on hand?

[Bryan McKeag:]

We got cash on hand. We got cash on hand for that as well as for the cash in the acquisitions that we have announced.

[Daniel Cardenas:]

Okay. Great. All my other questions have been asked and answered, so thank you and congratulations Ken.

[Ken Erickson:]

Thanks, Dan.

[Operator:]

Thank you. At this time, we have no further questions. I will turn the floor back over to Mr. Fuller for closing comments.

[Lynn Fuller:]

Thank you, Sherry. In closing, I am very pleased with Heartland's excellent financial performance for the second quarter of 2015. This strong quarter and especially the strong first half performance demonstrates our success in implementing our master strategy at balanced profit and growth as we continue to pursue our historic goal of doubling both, earnings and assets every five to seven years. I would like to thank everybody for joining us today and hope you can join us again for our next quarterly conference call, which will be on October 26, 2015. With that have a good evening everyone.

[Operator:]

Thank you. This does concludes today's teleconference. You may disconnect your line at this time. Thank you for your participation.